January 31, 2009

Nationalize the Banks After, Not Before They Go Bankrupt

That was Hank Paulson’s big mistake. He partially nationalized the big banks before they went under. He rescued them before we could gain control. The result is that we – the American people – are the largest shareholders of Citibank (with 7.8% of their equity) and of Bank of America (with 6% of theirs), and yet we have no way to really influence their lending practices, no way to make them thaw the frozen credit markets, nor any way to stop them from lining their pockets with our tax money.

But there’s one easy way to put an end to all this debate. Next time, we should let the big banks go bankrupt. We shouldn’t rescue them. We should only step in and nationalize right when they’re closing their doors – not before, as the Bush administration did. After all, if we’d let Merrill Lynch go under by not bailing out Bank of America – the way we let Lehman Brothers go down – those “bonus-bankers” would not be arguing about their entitlement to bonuses, nor about their need for incentives and hard work, nor about their merit. They’d be looking for a job like the other 100,000 + of their own employees that they laid off over the past two years – or like the nearly 2 million Americans who’ve lost their jobs since the banks’ financial landmines exploded.

My colleague, Andrew Rosenfield, argues that rescuing insolvent banks “is far superior to formal nationalization or receivership when that means assuming total direct operating control of institutions as complex as, say, Citibank or Bank of America—especially if the goal is to immediately empower those institutions to lend again.” I’m afraid that what the bonus fiasco just revealed is that those institutions cannot be trusted to use our money wisely – under any circumstance.

So, we can end the whole bonus debate very quickly by simply not rescuing the banks next time around. And, it turns out, there’s a bonus for us: there are better ways to use the TARP money. Giving another tranche of TARP money to the banks is clearly not efficient or wise. Instead, we should invest directly in ailing homeowners – or homeowners and renters more broadly. There are a number of proposals to do just that and they probably represent a far better use of the TARP. I’ll come back to those alternative proposals in a later post. But the bottom line is that we should make sure that the Obama administration does not infuse more of the TARP money directly into the banks. They’ve demonstrated that they are not using it wisely.

One last note. There is one refrain that I simply cannot stand. “If you’ve never worked on Wall Street,” we are told, you won’t understand the bonus issues. I’m sorry, that’s nonsense. I worked on Wall Street. In fact, before going into law, my official title was Wall Street Banking Officer at the bank that’s now called J.P. Morgan Chase. Those bonuses – coming on the heels of over $300 in TARP bailouts, record financial losses for the year 2008, and record lay-offs at those very same banks – are unforgivable. Entirely unforgivable. And it has nothing to do with whether you are on Main Street or Wall Street – or whether you’ve ever worked in a financial institution.

Money is fungible. It's impossible to demonstrate that the bonus money was the money invested by the government. Perhaps the other equity investors in these banks wanted their investments spent on recruiting and retaining top talent. Though it has no legal basis to force a claw back, as a matter of logic and finance, it only makes sense for the government to demand that that portion of the bonuses representing the government's proportion of equity (7% at most, in Citi, I believe) be "clawed" back.

And how about the class argument going on here? Presumably Bernard is ok with the money going to the auto companies. No one disputes that much of that money will be spent on employee salaries (indeed, such use was one of the justifications for the auto bailout). And it's clear that many auto industry employees receive wages and salaries far in excess of what the "market" would pay such people. Where's the outrage at this give away? At the very least, Bernard should demonstrate that the Wall Street bonuses were all going to people who didn't "need" the money whereas the autoworkers do "need" the money. In making that argument, he could draw on his extensive Wall Street experience.

Lastly, is it really that obvious that those still with jobs on Wall Street don't, on a superficial analysis (like Bernard's), "deserve" their biggest bonuses ever. BOA and Merril did not go the way of WaMu and Lehman, presumably because some folks at the first two firms performed better than their counterparts at the latter two.

I am a little confused by this outpouring of affection for executives at bailed out banks. Some of these people are directly responsible for the banks' circumstances and they ought to be fired. This is precisely what would happen if a private equity investor were rescuing a mucked up business. That is what the government is doing. Firing present management is a routine step of investing in distressed companies. I think a claw back is fine too, if it is legally possible. Awarding bonuses to idiots will not help anyone recruit top talent. This is because such bonuses do not appear to be performance-driven.

As a general matter, the intuitive yardstick is whether a private rescue investor would allow such large bonuses to be doled out in these businesses. I doubt it. Goldman Sachs executives wrote to their board and asked not to be paid bonuses. UBS and Citi followed similar paths. Tellingly, I think the Goldman move came from management and not from shareholders. This is probably not because shareholders loved Goldman's executives more than the executives loved themselves, but rather because shareholders are unable to control executive pay.

The main problem with the bail out money appears to be that the government is giving it away with very few strings attached. No private investor would be so careless.

Greed is the core value and motivation on Wall Street, so why should we be surprised? They will keep their hand in the cookie jar until someone slams the lid on it, hard. Jawboning is worthless.

The BK argument has a lot to recommend it. It scrapes off the shareholders, dumps current management (hopefully without their bonuses and golden parachutes) and it gets rid of toxic assets at fair value, but it also has downsides.

It would terrify the American public, destroy their confidence in the economy even further and it would raise serious questions about whether or how far we want to be in the business of managing America’s banks during bad times and in a liquidity trap. Is our handing of the bailout a good indicator of how we would fare as bankers? Should we be less prudent lending than they are now, for example?

Hey, what is the matter with bailing out crooks and protecting their pocketbooks? The basic work of government and law is and has been to protect and promote the well heeled. We should not kid ourselves now that it is otherwise.

Part of the problem is that the term "bonus" is mis-used. If these bankers had simply earned a salary (refered to as a "base" on Wall Street) of $500,000 over the year this issue would not have come up. These bonus ammounts have been accrued as compensation costs on the bank's books all year - they don't just materialize in December. If the same person makes a base of $125,000 and a single year-end payment of $375,000, it sounds worse to pay the "bonus."

Certainly a U of C debate should appreciate the power of potentially losing ones "bonus" for poor performance, or getting a larger bonus for better performance - even if the total compensation is the same in the end.

Also, has anyone examined how much of the bonuses go to junior, medium-level or senior people. Is a staff member who earns a salary of $50,0000 getting a standard $5,000 bonus different from a MBA with a base of $150,000 getting a $150,000 bonus (down from $450,000 last year)?

This debate assumes we are only talking about the MD or agressive trader with a base of $175,000 and a bonus of $1mm. However, even that unsympathetic lady certainly can not live in Manhattan and support her family on $175,000 (at close to 40% total tax rate in the City, she'd be left with about $5,800 a month...rents for a nice 2-bedroom cost around $6,000 to $15,000).

I propose that Law Professors go to a base plus bonus system. Base would be 30% of current compensation. Bonus could be between zero and 90 (so including base equal to 20% more than current comepnsation for the "top" people). Since the government pays a lot of University operating costs, we'd then have to eliminate the bonuses.

Bonuses are a significant part of the way employees at banks are compensated. It is politically unfortunate that the banks call the compensation a “bonus” rather than “salary” or “money that our employees will use to pay their mortgages.”
The amount of the bonuses doesn’t really have any meaning without comparing it to bonus levels in past years. If bankers are taking home twice as much as last year, maybe we should worry.
I also suspect that a large portion of these bonuses are not discretionary and the banks were contractual obligated to pay them.

I got censored out (probably for cynicism indicating a "bad" attitude) the first time I commented here, but I try again now. To be sure, the worst of this economic mess is still ahead of us. We are in a liquidity trap so conventional monetary policy does not work and the bailout program will not fix that. Obama just yesterday said (a) the Administration needs more bailout funds and (b) even then, some banks will still fail. (How many and which ones, are the real questions.) Too, the stimulus package is being frittered away on too much of the Democratic social agenda without good enough consideration of how should the money be best spent to provide the most new and useful employment and the greatest increase in aggregate demand. The key point here is, if the bailout program and stimulus package both fail, as is increasingly likely, Prof Harcourt will get what he wants here. If a bank goes BK, the stockholders would be wiped out, the management, chucked (hopefully without bonuses and golden parachutes), the toxic assets would be sold off at fair prices and new bankers would step in to buy what was left and run it. Many, like Prof Harcourt, think this is a preferred solution. We will surely get to see in some instances. Is that better?

These are excellent points. I think I overshot somewhat earlier; it's true that business executives' salaries are structured differently with larger proportions being classified as bonuses.

But one reason for that difference is that the bonuses are supposed to be linked to performance. The bifurcation of wages into (i) base salaries and (ii) bonuses is meant to reduce agency costs by allowing principals to control agents' actions without having to specify by contract every minute detail of the agents' performance. This is why the notion of a "guaranteed bonus" seems odd. There is no difference between a guaranteed bonus and a salary from an economic point of view, so there must be some non-economic reason for such a mutant.

Insofar as bonuses are not guaranteed, you would expect them to be lower than (not equal to) last year's, presumably because the executives have performed worse this year. The mess was a while in the making, but the effects are peaking and being realized now. We should be suspicious of bonuses equal to, not greater than, last year's.

I also understand that the criticism of executive compensations is unlikely to do much to fix the economy; some have noted that we have bigger problems to worry about and that this issue may be a distraction. We should not miss the forest that is the economy for the trees that are executives. Yet, re-configuring compensation schemes might do more to avoid such crises in the future than we think. This fiasco would have been impossible but for the way mortgage-backed securities and their derivatives were rated and traded. Even if the government indirectly encouraged this market, banks and investors should have known that an implosion loomed. The fact that they did not suggests that we ought to tweak their incentives.

A point to be inferred from my last comment is that once a bank has properly gone through a bankrupty reorganization and then has been sold out of bankrupty reorganized as I described, there is no need then to nationalize it. Regulation is enough.

There are two positions. The first is "[bank] executives are overpaid". It is difficult to evaluate this position. Sometimes it expresses the speaker's jealousy. Sometimes it expresses a well thought out argument based on agency costs and the difficulty of negotiating compensation with the babysitter (exec) before you (shareholders) leave her with your kids (firm). There have been many efforts devoted to evaluating this position. See, for example, Harvard Business Review on Compensation (Harvard Press 2001).

The second position is that given the recent performance of banks, discretionary comp should be set at zero. This is not an "executives are overpaid" argument, this is simply an argument that the compensation committees at the relevant banks should not have awarded bonuses b/w 50-70% of the prior's years when the banks were incurring record losses (it is similar to if less generous than Mr. Kayani's point that bonuses should be less this year than last, which they are). This position asks, when, if not now, should the discretionary, performance based components of executive compensation be set at zero?

A potential response to that position is that the executives receiving the bonuses may have actually done a good job given the economic conditions. Someone offering that response, however, must ask whether last year, when these same executives received performance based bonuses, were those bonuses tied to their performance or the firm's? It may appear inconsistent to reward someone based on her average performance in a great industry one year, and then reward her for superior performance in a sour industry the next. Executive compensation, however, has many components. Some components reference individual performance (and would kick in for a superiod executive in a firm heading for insolvency) and other components reference firm performance (and kick in for executives who did little right except join a great firm). For more information on executive comp at a company (e.g. a bank being criticized for lavish comp) look at its proxy statement filed under Section 14A of the Exchange Act. For more information on how executive compensation is structured to recognize individual performance and allign executive interest with that of the shareholders, see, for example, Ellig's book "The Complete Guide to Executive Compensation".

We are arguing and tangled up here on the minor issue of how much bankers should be paid and in what form. That is a truly incidenal matter. What about Prof. Harcourt´s basic proposition in this post that banks should not be bailed out but instead run through bankruptcy reorganizations?

The Tax Professor Blog (Feb 3) has a link to an interesting proposal on Daily Kos, dated January 29th: instead of clawing back bonuses, the government could impose a tax ex post. The theory is that the prohibition against ex post facto laws only applies to punitive sanctions and not to civil penalties. I think this is dicey but it's out there.

Great set of comments and fascinating discussion. I'm in Ann Arbor right now, giving a paper at the University of Michigan (actually, a paper called "Neoliberal Penality"), but I'll be back this weekend and will weigh in on some of these issues. Warm regards, Bernard Harcourt

ps. the paper "Neoliberal Penality" can be downloaded here if you are interested:

Roughly, the government could refuse to rescue existing banks. All the TARP money could be invested in newly formed banks as equity. The government could later sell its equity stakes in the new banks. If the new banks were required to limit leverage to 10:1 and they started off with clean balance sheets, then fractional reserve banking would multiply the TARP money nicely.

Existing banks would then enter "bankruptcies," though remember that the Bankruptcy Code does not cover bank insolvencies. Banks typically go into receivership under the Federal Deposit Insurance Act. Under that Act, bank receivership is significantly different from corporate bankruptcies. I am not familiar enough with it to say if the corporate bankruptcy analogy holds. Here is a good review of the differences between the two regimes: